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What’s the Difference Between Passive Investing and Tactical Asset Allocation?

Recently we wrote a post about Tactical Asset Allocation and how tough it can be to execute effectively. That in turn set off a discussion of the lack of meaning in terms like “buy-and-hold” and “tactical asset allocation.” I was accused of setting up a false dichotomy. There are stocks that you buy and hold. You do that because they continue to do well, argued Roger Lowenstein. But you do have to be willing to let go of the ones that aren’t working.

Lowenstein believes in stock-picking, but if you don’t think that you have that skill, or if you want to balance a few such picks with a broader diversified approach, then you may indeed be interested in the passive v. allocation debate.

In a recent post on his Wise Investing blog, Larry Swedroe sought to better explain just what passive investing in. It is not “by and hold.” Passive investing is passive, but not pulse-less.

The Difference Between Active Investing and Passive Investing

Here is how Swedroe explains the difference between active and passive investing:

Active management holds that the markets are inefficient. Thus, smart people working diligently can discover which stocks are undervalued and buy them. And, they can discover which stocks are overvalued and avoid them (or even sell them short). That’s the art of stock selection.
Active investors also believe they can anticipate when the bull is going to enter the arena and buy stocks ahead of the rally (or avoid stocks before the bear emerges from hibernation). This is the art of market timing. Stock selection and market timing combine to form active management.
Passive management means believing that markets are highly efficient. In turn, this means the market price of a security is the best estimate of the right price, and efforts to outperform are unlikely to prove productive after the expenses of the efforts.

A passive investor writes “an investment policy statement (IPS) with an asset allocation plan based on assumptions about their unique ability, willingness and need to take risk. The plan defines the target amount they will invest in each asset class,” Swedroe writes. When it gets too far out of whack he or she rebalances.
Sometimes things will change in the investor’s circumstances that will change the allocation. Aunt Emmie leaves them $1 million. Now they have more principle to invest, and no longer have to take as much risk to get to their financial goals, for example. Or they have another kid, struggle to save as much, need to dial up the risk to meet the end goal. What they don’t do is make bets on the markets. Broad macro economic trends don’t play a part in their allocation, only the micro economic trends of their own family balance sheet and income statement affect that.

One Breed of Active Investors: Tactical Asset Allocators

On the other side of the ring we have active investors. Active investors can be stock pickers like Lowenstein, or they can embrace the idea of Tactical Asset Allocation, the idea that it is possible to read the tea leaves of broader economic trends and get heavy into US Treasuries when the signs point to a run in bonds, then back off and buy up emerging markets small caps, for example, when signs point to a good year for small firms in those countries.

Swedroe is an ardent fan of passive investing and a complete non-believer in all forms of active management, including Tactical Asset Allocation. His primary reason: active managers tend to under-perform the market. The odds are against this working. “If people could tactically asset allocate, active mangers would win all day long, but they don’t, ” he said in an interview after his post went up. “It’s possible to beat the market by Tactical Asset Allocation, but not likely.”
To back up his position, Swedroe sites a study that is described in David Dreman’s book Contrarian Investment Strategy that found between 1986 and 1997, the return of an S&P 500 index fund was 734%, the average of all equity funds was 539%, while the 186 Tactical Asset Allocation funds tracked returned a much lower 384%. Studies by others, including Mark Hulbert, found similar under-performance.

To Swedroe, the numbers just don’t lie.

Later in the week, we’ll hear from a believer in Tactical Asset Allocation to get their take on this debate.

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